The New UK Regime for Offshore Funds: grandfathering arrangements and other transitional provisions

Transcription

1 The New UK Regime for Offshore Funds: grandfathering arrangements and other transitional provisions By Sarah Gabbai and Tony Stitt Reprinted from British Tax Review Issue 4, 2010 Sweet & Maxwell 100 Avenue Road Swiss Cottage London NW3 3PF (Law Publishers)

2 310 British Tax Review The New UK Regime for Offshore Funds: grandfathering arrangements and other transitional provisions In the writers earlier British Tax Review note An Overview of the New UK Regime for Offshore Funds, 1 it was mentioned that a separate note on grandfathering provisions and transitional arrangements would follow. Accordingly, this note looks closely at some key areas of interaction between the pre- and post-december 1, 2009 offshore fund regimes, with particular reference to the Offshore Funds (Tax) Regulations (the 2009 Regulations), the Offshore Funds (Tax) (Amendment) Regulations (the Amendment Regulations), and recent guidance from HM Revenue & Customs (HMRC) in their Offshore Funds Manual (the Manual). 4 Key areas include investor taxation of income and gains from transparent funds and the advantages of reporting fund status conversions from the pre-december 1, 2009 regime to the post-december 1, 2009 regime and one or two issues left unresolved from the writers earlier note 5 which HMRC have since addressed. Australia; Minerals taxation; Small businesses; Tax reform; VAT * Professor of Taxation, The University of New South Wales. ** Professor of Business Law and Taxation, Monash University. 1 Sarah Gabbai and Tony Stitt, An Overview of the New UK Regime for Offshore Funds [2010] BTR 1, The Offshore Funds (Tax) Regulations 2009 (SI 2009/3001). These regulations came into force on December 1, 2009, available at [Accessed June 29, 2010]. 3 The Offshore Funds (Tax) (Amendment) Regulations 2009 (SI 2009/3139). These regulations came into force on December 22, 2009, available at [Accessed June 29, 2010]. 4 Offshore Funds Manual. Released on May 18, 2010, available at [Accessed June 29, 2010]. 5 Gabbai and Stitt, [2010] BTR 1, above fn.1.

3 Current Notes 311 Since April 1, 2010, the definition of an offshore fund has been rewritten under Part 8 of the Taxation (International and Other Provisions) Act 2010, 6 (the 2010 Act) which replaces sections 40A to 40G of the Finance Act Neither set of Regulations nor the Manual refers to the 2010 Act, so further amendments may be needed to link these to the 2010 Act in due course. However, it should not make any difference to the operation of the post-december 1, 2009 regime, since both definitions are substantially the same. Since the definition of an offshore fund has already been discussed at some length in the writers earlier note, 8 the writers do not propose to discuss it further here. It is worth mentioning, however, that HMRC are now prepared to give an opinion as to whether a fund meets the post-december 1, 2009 definition of an offshore fund, provided that there is still material uncertainty even after considering available guidance. 9 This may be useful to investors and fund managers as a fallback position if all else fails, although they should bear in mind that it is their responsibility to make the initial determination, with help if necessary from their advisers. If investors are unable to determine whether the fund meets this definition, and this point is material to a share issue, queries should be sent to HMRC at least 28 days in advance of the proposed issue. Accordingly, references to offshore funds in both sets of Regulations and the Manual should be read with these recent developments in mind. Grandfathering provisions: income tax exemption The main grandfathering provisions are in regulation 30 of the 2009 Regulations. Under regulation 30, investors are income tax-exempt on gains realised from disposals of non-material interests 10 in an offshore fund (as defined under the pre- and the post-december 1, 2009 rules) acquired either prior to December 1, 2009, or, broadly, after December 1, 2009 but pursuant to an unconditional written agreement entered into before April 30, 2009 ( grandfathered interests ). Regulation 30 also has an income tax exemption for gains realised from interests in non-uk funds that meet the post-december 1, 2009 definition but which did not meet the pre-december 1, 2009 definition under Chapter 5 Part 17 of the Income and Corporation Taxes Act 1988 (ICTA). This note deals with the first-mentioned exemption. Grandfathering provisions: income tax exemption and transparent reporting funds (TRF) Transparent funds are offshore funds within the post-december 1, 2009 regime that are transparent for income purposes but opaque for gains. These include Baker unit trusts 11 such as Jersey Property Unit Trusts (JPUTs) and Luxembourg Fonds Commun de Placement (FCP) 12 6 Taxation (International and Other Provisions) Act. In force as of April 1, 2010, available at /acts/acts2010/ukpga_ _en_1 [Accessed June 29, 2010]. 7 Inserted by FA 2009 Sch.22 para.2. 8 Gabbai and Stitt, [2010] BTR 1, above fn.1. 9 Offshore Funds Manual, above fn.4, OFM02050, OFM A non-material interest is any interest that is not a material interest within the meaning of ICTA s.759 under the pre-december 1, 2009 regime. 11 Archer-Shee v Baker (HM Inspector of Taxes) (1927) 11 TC 749 HL. 12 Offshore Funds Manual, above fn.4, OFM08200.

4 312 British Tax Review but not partnerships, LPs or LLPs. TRFs are thus transparent funds with reporting fund status. (For simplicity, a transparent fund without reporting fund status is referred to in this note as a TNRF and a transparent fund generally as TF ). The tax treatment of reported income from a TRF under regulation 94(2) of the 2009 Regulations is inconsistent with the arising basis of taxation under regulation 11 of the 2009 Regulations. Regulation 11 taxes all TF income on an arising basis, whereas regulation 94(2) taxes on an accruals basis any excess reported income from a TRF over its other income for the reporting period. Under the accruals basis, reportable income accrues to the TRF in the accounting period to which it relates under International Accounting Standards (IAS). 13 The accrued income is then reported to investors and taxed in proportion to their interests. It is not clear which regulation, if any, takes precedence over the other, nor is it entirely clear how these two provisions interact. To the extent that investors hold grandfathered interests in a TRF, reported income from those interests is income tax-exempt. 14 The tension between regulations 11 and 94(2) thus creates a particular tax uncertainty for grandfathered interest holders. If regulation 11 takes precedence, all income would be taxable on an arising basis so that there is no excess of reported income over other fund income within the meaning of regulation 94(2), and hence no reported income to benefit from the above exemption. Alternatively, if regulation 94(2) trumps regulation 11, all accrued reported income would be exempt. Because of this confusion, the net effect is that grandfathered interest holders of a TRF are either wholly taxable or wholly exempt in respect of their TRF income. The question is, which one is it? An arising basis of taxation generally implies that an investor is liable to taxation when he receives income, becomes entitled to receive income, or (in certain cases) is deemed to receive income. 15 In practice, many TFs, notably certain types of unit trusts, often pay distributions, and investors become entitled to receive these distributions (and are taxable accordingly) when the fund s accounts show amounts available for distribution. The Manual 16 states that, in the case of TRFs, any excess reported income over those distributions is treated as additional income in proportion to their rights, and subject to income tax accordingly. This guidance, when read together with regulation 94(2A), suggests that such excess should be income tax-exempt to the extent that these rights are grandfathered. However, it does not fully resolve the issue, since it is neither clear which income counts as arising basis income, nor which income counts as reported income; nor indeed is it clear the extent to which, if at all, the two overlap. The Manual sheds some light on this inconsistency 17 by stating that TRF income is treated as arising directly to investors in proportion to their shares (net of a deduction for proper expenses of management of the fund), which suggests that regulation 11 takes precedence over regulation 94(2). For example, when a TRF receives interest, investors are taxed on their proportionate share of that interest, whether or not it is actually distributed to them. 13 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.94(2a), (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 15 Savings and Investment Manual, SAIM 2400, 5040 and Offshore Funds Manual, above fn.4, OFM Offshore Funds Manual, above fn.4, OFM15680.

5 Current Notes 313 However, the Manual also states that if a TRF holds investments in other reporting funds, investors are taxed on their proportionate share of any excess income reported by those sub-funds in accordance with regulation 94(2). According to the Manual, excess reported sub-fund income becomes part of the excess to be reported by the TRF, which is then taxed as miscellaneous foreign income under Chapter 8 Part 5 of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) at investors highest tax rate. 18 Such excess would presumably be the additional income in proportion to investors rights within the meaning of regulation 94(2), which is then exempted by regulation 94(2A) to the extent that the investors interests are grandfathered. The phrase part of the excess is slightly confusing, since it implies that a TRF must report any undistributed income notwithstanding the fact that such income is supposed to be taxable on an arising basis. In order for the Regulations and Manual guidance to make any sense, a logical interpretation might be as follows: income from reporting sub-funds is reported to the TRF, at which point it becomes income to be reported by the TRF, which should be income taxexempt under regulation 94(2A) to the extent that the investor s interests are grandfathered. If correct, the tax treatment of investors in TNRFs with reporting sub-funds is similar to that of investors in TRFs with reporting sub-funds, albeit with some minor differences. In a TNRF, income from reporting sub-funds is treated as additional income arising to investors on the same date as it is treated as made to the TNRF 19 ; whereas in a TRF, income from reporting sub-funds is likely to be treated as arising when the TRF issues a report to investors, as explained further below. (Another difference in tax treatment between TRF and TNRF investors under these circumstances is that, on a later disposal, a TNRF investor does not get a deduction for accumulated reportable income from reporting sub-funds in calculating offshore income gains). 20 Such an interpretation ensures that regulation 11 and regulation 94(2) do not clash. That way no double taxation occurs due to timing differences between reported income treated as arising, and other income so treated. Reportable income, which is essentially trading income, can be treated separately from other (non-trading) income. If the above interpretation is correct, it follows that reported sub-fund income ought to be treated as a separate income stream for a TRF. This should be treated as arising to investors for tax purposes when the fund sends them a report, or at the end of a reporting period (the fund distribution date ). 21 The fund distribution date for reported income may or may not coincide with the accounts distribution date for dividend or interest distributions, being the date on which the TRF s accounts show amounts available for distribution or, if the income is accumulated, the end of its accounting period. It may also be a separate tax event for investors if the fund distribution date falls in a separate tax year from the accounts distribution date. 22 It should therefore follow that, where a TRF holds no reporting sub-funds, there is no reported income, and the arising basis of taxation should apply as per regulation 11. It should also follow 18 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.97(4) and Offshore Funds Manual, above fn.4, OFM The Offshore Funds (Tax) Regulations 2009, above fn.2, reg The Offshore Funds (Tax) Regulations 2009, above fn.2, regs 39(1) and The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.94(3) and (4). 22 Interest or dividend distribution dates for income shares (as opposed to accumulation shares) typically occur quarterly or half-yearly depending on the composition of the fund.

6 314 British Tax Review that, where an investor owns shares in a TRF with reporting sub-funds, the investor ought to be taxed on reported income from those sub-funds when the TRF reports that income to the investor, since that income should be treated as arising to the investor on that date for regulation 11 purposes. To the extent that the investor s interests are grandfathered, such reported income should be income tax-exempt under regulation 94(2A). As the above analysis demonstrates, reporting fund status should be more appropriate for investors with substantial grandfathered interests if a TF owns reporting sub-funds. Reporting fund status may also be a better option for commercial reasons, since it removes the need to physically distribute income, and may attract a wider investor base due to its perceived attraction in the marketplace. However, in certain circumstances, non-reporting fund status may be more appropriate for TFs now that HMRC have confirmed favorable tax treatment for investors in TNRFs with holdings in other TNRFs. 23 Consequently, TFs and their structures may need to be considered on a case-by-case basis as regards whether to opt for reporting fund status. In doing so, investor ownership of grandfathered interests would be a key factor to consider. Because regulation 30 does not apply to material interest 24 holders of existing funds, 25 these investors do not benefit from the above grandfathering treatment. From a policy perspective, this makes sense, given that material interest holders were already within the pre-december 1, 2009 offshore funds regime and so did not face the same iniquity of being caught unawares by the prospect of realising offshore income gains under the 2009 Regulations. If an existing fund 26 is a TNRF, material interest holders benefit from a separate income tax exemption for offshore income gains subject to certain conditions, 27 with possible capital gains tax ( CGT ) consequences instead. As it can be difficult for fund managers to ensure that the relevant TNRF conditions are met for investors relying on this exemption, managers typically opt for reporting fund status, although the Manual suggests that this is not strictly necessary in some cases. 28 Material interest holders still face the same uncertainty as to whether a TRF s income is taxable on an arising or accruals basis, although the issue is one of timing, rather than whether the income is taxable at all. The Manual may have resolved this issue, assuming the above interpretation is correct. Grandfathering provisions: further acquisitions of interests in existing funds post-december 1, 2009 HMRC have also confirmed that where an investor holds protected rights and later acquires additional interests in an existing fund 29 post-december 1, 2009 ( non-protected rights ), the share identification rules under section 104 of the Taxation of Chargeable Gains Act 1992 (TCGA) apply on a subsequent disposal of interests in that fund on the basis that the protected 23 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.29(4). Offshore Funds Manual, above fn.4, OFM As defined under ICTA s Offshore funds as defined under the pre- and post-december 1, 2009 regimes, whether transparent or opaque. 26 Above fn The Offshore Funds (Tax) Regulations 2009, above fn.2, reg Reporting fund status may be necessary, for example, if the TF wishes to invest more than 5% of its investments by value in opaque non-reporting funds, but may not be necessary if the TF holds other TNRFs. 29 As defined under the pre- and post-december 1, 2009 regimes.

7 Current Notes 315 rights are treated as a different class from the non-protected rights, and are thus disposed of first. 30 ( Protected rights are essentially the same as grandfathered interests, as defined above). Grandfathering provisions: share for share exchanges When an investor exchanges shares in a distributing fund for a different class of shares in a reporting fund within the same umbrella arrangements, 31 reorganisation treatment under section 127 of TCGA applies. 32 The Manual also confirms that treatment under sections 135 and 136 of TCGA is preserved for exchanged protected rights. 33 Transitional arrangements: conversion of pre-december 1, 2009 offshore funds 34 to post-december 1, 2009 offshore funds The writers earlier note 35 included a short section on transitional arrangements for converting funds from the pre-december 1, 2009 regime to the post-december 1, 2009 regime, under the following scenarios: 1. non-distributing funds to reporting funds 36 ; 2. distributing funds to reporting funds; 3. non-distributing funds to non-reporting funds; and 4. distributing funds to non-reporting funds. 37 These provisions merit more detailed attention, since they are often relevant in practice. Scenarios 1 and 4 involve deemed disposal election mechanisms. Non-distributing funds to reporting funds Where a non-distributing fund converts to a reporting fund, and an investor makes an election, he is treated as disposing of his holding in the non-distributing fund at market value, which crystallises an offshore income gain in accordance with Chapter 5 Part 17 of ICTA. 38 Gains from later disposals of interests in the reporting fund are taxed as capital gains, with the acquisition cost being rebased to the start of the first accounting period for which it was treated as a reporting fund. It is particularly important for investors to make this election if available, even if the fund has successfully applied for reporting fund status, otherwise investors will later suffer income tax 30 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.43, and Offshore Funds Manual, above fn.4, OFM Offshore Funds Manual, above fn.4, OFM For a definition of umbrella arrangements see section below on Transitional arrangements: umbrella arrangements. 32 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3c (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 33 Offshore Funds Manual, above fn.4, OFM08700 and OFM As defined under ICTA s.765a. 35 Gabbai and Stitt, [2010] BTR 1, above fn The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.5 and reg The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.48(3) and Sch.1 para.5. The writers previously thought that this event triggered capital gains tax, and the treatment was described as such in their earlier note, above fn.1.

8 316 British Tax Review on an offshore income gain based on the entire period of ownership, 39 which could potentially be significant. An election will only be available for these purposes if the offshore income gain resulting from the election is greater than zero. 40 In other words, an investor cannot crystallise an offshore income loss. 41 The Manual suggests that such elections are appropriate for investors in non-distributing funds with accounting periods ending on November 30, 2009, so that the fund is treated as a reporting fund with effect from December 1, 2009 (assuming the application meets the relevant criteria and is made within the time limits discussed further below). 42 The Manual does not make it clear whether this also means that a fund had to be a non-distributing fund right up until November 30, 2009 in order for this election to be available. Many fund managers and investors have sought advice on the correct treatment for funds that have temporarily transitioned from non-distributor to distributor status before becoming reporting funds, which neither the Regulations nor the Manual directly address. However, if an existing 43 fund s accounting date fell on November 30, 2009 (as opposed to a fund whose accounting period straddles December 1, 2009, which is discussed further below), it is understood that HMRC may, as a matter of policy, invoke this election mechanism. This would be consistent with the UK Government s earlier intentions set out in HM Treasury s Consultation Paper of December 2008, 44 which confirmed that the election mechanism would be extended to investors in existing funds 45 who were anticipating offshore income gains under the pre-december 1, 2009 regime, owing to the fact that the fund had not always obtained distributor status throughout the investor s period of ownership. If an existing 46 fund s accounting period straddles December 1, 2009, it may apply to HMRC for distributor status in respect of that overlap period, and if it so wishes, for the period succeeding that overlap period ( relevant periods ). 47 This option is available to both non-distributing and distributing funds if the distributor status tests under the pre-december 1, 2009 regime are met for each relevant period, 48 provided that the application relates to periods ending on or before May 31, The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.17(3) (Condition B criteria). 40 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.48(5). 41 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg Offshore Funds Manual, above fn.4, OFM As defined under ICTA s.765a. 44 HM Treasury, Offshore Funds: Further Steps (December 2008), Ch As defined under ICTA s.765a. 46 As defined under ICTA s.765a. 47 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3; Offshore Funds Manual, above fn.4, OFM ICTA Sch.27. The pre-december 1, 2009 distributor status rules are preserved for overlap and succeeding periods notwithstanding the fact that they fall (or partly fall) after December 1, Offshore Funds Manual, above fn.4, OFM Although OFM17650 mentions a cut-off date of May 31, 2012, it also cross-refers to Schedule 1, paragraph 3B, which deals with the ability of post-december 1, 2009 offshore funds under the same umbrella arrangements as an existing fund (within the meaning of ICTA s.765a) to apply for distributor status under certain circumstances. Paragraph 3B states that the cut-off date is May 31, It is unclear whether HMRC intended different cut-off dates for standalone existing funds and post-december 1, 2009 offshore funds under the same umbrella arrangements as existing funds.

9 Current Notes 317 If the fund becomes a reporting fund for the period immediately following a relevant period, it is treated as a reporting fund continuously for the entire relevant period. 50 Investors should thus realise capital gains on a later disposal. Under these circumstances, an investor s base cost for CGT purposes should be equal to the value of his interest at the start of the relevant period, plus any accumulated reported income already taxed as income. 51 If the distributor status tests are not met for the entire relevant period, or the fund does not become a reporting fund immediately thereafter, gains realised on later disposals may be taxable as offshore income gains 52 rather than capital gains. Distributing funds to reporting funds If the fund had consistently been a distributing fund throughout the entire period of ownership, then no election need be made if the fund wishes to become a reporting fund. 53 All that is required is an application to HMRC within the relevant time limits for treatment as a reporting fund. If the application is successful, and assuming there are no breaches of the relevant reporting fund requirements, any later disposals will realise capital gains. Again, this is consistent with the guidance set out in the HM Treasury Consultation Paper referred to above. Non-distributing funds to non-reporting funds A non-distributing fund automatically becomes a non-reporting fund on December 1, If it wishes to apply for reporting fund status it must make an election under regulation 48 of the 2009 Regulations in the manner described above. Distributing funds to non-reporting funds There is a separate deemed disposal election for distributing funds converting to non-reporting funds. This crystallises CGT on a deemed disposal at Net Asset Value (NAV) 54 if an investor so elects. The acquisition cost of his non-reporting fund holding for the purposes of any later offshore income gains is rebased to the point immediately following the last day of the distributing fund s accounting period. Unlike regulation 48 of the 2009 Regulations, which prevents the crystallisation of offshore income losses, there is nothing in paragraph 4 of Schedule 1 to the 2009 Regulations to prevent the crystallisation of capital losses under these circumstances. If no election under paragraph 4 of Schedule 1 to the 2009 Regulations is made, the fund will automatically be treated as a non-reporting fund as of December 1, 2009, without the benefit of rebasing or crystallisation of capital losses. 50 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para Offshore Funds Manual, above fn.4, OFM15760; the Offshore Funds (Tax) Regulations 2009, above fn.2, reg.99(2). 52 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.6(2) and (3); reg.17(3). 53 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.5(1) and (2). 54 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.4.

10 318 British Tax Review Transitional arrangements: umbrella arrangements Umbrella arrangements are arrangements that provide for separate pooling of investor contributions and profits or income out of which payments are made to them. 55 Where a fund (or sub-fund) is part of umbrella arrangements within the meaning of the relevant rules, it is treated as a separate offshore fund. Similarly, separate classes of interest are treated as separate offshore funds. The umbrella arrangements themselves are disregarded. HMRC guidance confirms that the same treatment applies to individual cells of protected cell companies. 56 The Amendment Regulations allow offshore sub-funds and separate interest classes 57 established on or after December 1, 2009 to apply to HMRC in writing to be treated as distributing funds under certain circumstances. 58 These are as follows, namely that: 1. there must be an existing fund 59 under the same umbrella arrangements; 2. the existing fund s 60 accounting period straddles December 1, 2009 (the overlap period), whose accounting reference date matches that of the new sub-fund or interest class; and 3. the existing fund 61 has already been certified by HMRC as a distributing fund in respect of that overlap period, 62 or the period immediately following the overlap period. The ability of existing funds 63 and post-december 1, 2009 sub-funds or interest classes under the same umbrella arrangements to apply for distributor status under these circumstances will no longer be available for periods ending after May 31, 2011, so these transitional rules are for a limited period only. 64 The idea is to ensure consistent treatment and operational efficiency across all sub-funds or interest classes within the same umbrella, and also to give fund managers enough time to transition funds within the same umbrella to reporting fund status. 55 Finance Act 2008 s.40c (re-written into Ch.8 of the Taxation (International and Other Provisions) Act 2010). See also Offshore Funds Manual, above fn.4, OFM Offshore Funds Manual, above fn.4, OFM Referred to as separate arrangements under the umbrella arrangements and classes of interest under the main arrangements respectively (The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3(3a)) (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 58 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3(3a) (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 59 A pre-december 1, 2009 offshore fund to which ICTA s.765a applied (the Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1). 60 A pre-december 1, 2009 offshore fund to which ICTA s.765a applied (the Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1). 61 A pre-december 1, 2009 offshore fund to which ICTA s.765a applied (the Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1). 62 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3(3a) (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 63 Pre-December 1, 2009 offshore funds to which ICTA s.765a applied (the Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1). 64 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3(3b) (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). The legislation is at odds with the May 31, 2012 cut-off date for existing funds not within umbrella arrangements applying for distributor status in respect of overlap periods (see section on non-distributing funds converting to reporting funds under Transitional Arrangements: Conversion of Pre-December 1, 2009 Offshore Funds to Post-December 1, 2009 Offshore Funds). In this regard see also fn.49.

11 Current Notes 319 Transitional arrangements: funds of funds with reporting and distributing funds Where a reporting fund holds an interest in a distributing sub-fund, income from the latter is treated as income from a reporting fund. 65 Normally, where a reporting fund (RF1) holds an interest in another reporting fund (RF2), the excess of reported income over any actual distributions from RF2 is included in RF1 s accrued income computation under IAS, after adjusting for certain capital items. 66 However, where RF2 is a distributing fund, RF1 does not have to make such an adjustment. 67 This exception makes sense, since to allow such an adjustment would be to impose reporting fund requirements unnecessarily on a distributing fund, potentially confusing the two regimes. Where a distributing fund holds an interest in a reporting sub-fund, the reporting sub-fund is treated as a qualifying fund within the meaning of Part II of Schedule 27 ICTA under the pre-december 1, 2009 offshore funds regime. 68 This means that material interest holders of pre-december 1, 2009 offshore funds with reporting sub-funds will not be affected by the 5 per cent test under the pre-december 1, 2009 regime when the top fund applies for distributor status. 69 The top fund s UK equivalent profits for distributor status purposes 70 is treated as increased by its share of excess reported income from the sub-fund over any amounts physically distributed. Other recent developments Launch of new post-december 1, 2009 offshore funds The writers earlier note 71 mentioned that a reporting fund application needs to be submitted within three months from the start of the accounting period in which the fund wishes to be treated as a reporting fund. Under the Amendment Regulations, this three-month time limit begins to run from the latest of: 1. the start of that accounting period; 2. the date on which the fund s first shares are issued to investors; and 3. in the case of an existing fund, 72 the first day on which the fund s shares are made available to UK resident investors. 73 Both Regulations effectively ensure that the period within which an offshore fund can apply for reporting fund status begins to run from the date of its launch. In practice, this will normally be 65 The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3a (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 66 The Offshore Funds (Tax) Regulations 2009, above fn.2, regs and 68(2). 67 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.68(2), and Sch.1 para.3a (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). These adjustments are for certain capital items in accordance with regs 64 and The Offshore Funds (Tax) Regulations 2009, above fn.2, Sch.1 para.3b (inserted by the Offshore Funds (Tax) (Amendment) Regulations 2009, above fn.3). 69 The 5% test under the pre-december 1, 2009 regime required that, for an offshore fund to be certified as a distributing fund, it must not hold (inter alia) more than 5% of its investments by value in non-qualifying offshore funds. 70 ICTA Sch.27 para Gabbai and Stitt, [2010] BTR 1, above fn As defined under ICTA s.765a. 73 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.54.

12 320 British Tax Review when the fund first issues shares to investors. If an application is made after these time limits, HMRC will allow late applications as long as they are received by June 30, Thereafter, offshore funds must abide by the time limits specified. Tax treatment of remittance basis investors in reporting funds Since the 2009 Regulations themselves do not address the tax treatment of remittance basis investors in reporting funds, the writers were unable to address this issue in their earlier note. 74 The Manual has since confirmed that the normal remittance basis rules 75 apply to income arising from a reporting fund. Reported income, as opposed to that which is physically distributed, is not remitted to the UK for the purposes of those rules. If the reporting fund is also a TF, income may sometimes be treated as arising in the UK due to the nature of the underlying assets. Such income does not benefit from remittance basis treatment. 76 Disposal proceeds from a reporting fund will normally constitute a mixed fund for the purposes of the remittance basis rules. This is because the proceeds may have been funded by undistributed reported income as well as by the original investment and any capital growth. 77 Tax treatment of investors in corporate non-reporting offshore funds holding mainly equities The writers earlier note 78 mentioned that the post-april 22, 2009 changes 79 to the tax treatment of distributions from corporate non-reporting offshore funds referred to the pre-december 1, 2009 definition of an offshore fund. 80 This left it unclear as to how distributions from post-december 1, 2009 corporate non-reporting offshore funds holding mainly equities were to be taxed. 81 HMRC now appears to have resolved this issue by confirming that dividends from corporate non-reporting offshore funds paid to individual investors on or after April 22, 2009 qualify for the dividend tax credit, 82 while dividends paid to UK corporate investors on or after that date are exempt under Part 9A of the Corporation Tax Act Conclusion The ostensibly favourable tax treatment for TNRFs under certain circumstances appears to cast some doubt on the value of reporting fund status. However, on balance, reporting fund status continues to be the more advantageous option. Aside from the income tax exemption for grandfathered interest holders of TRFs, TNRFs still have an obligation to provide investors with sufficient information to enable them to meet their tax obligations, 84 which is not much less 74 Gabbai and Stitt, [2010] BTR 1, above fn ITA s.809a. 76 Offshore Funds Manual, above fn.4, OFM Offshore Funds Manual, above fn.4, OFM Gabbai and Stitt, [2010] BTR 1, above fn ITTOIA s.379aa (as amended by FA 2009). 80 ICTA s.765a. 81 The tax treatment of distributions from bond funds as interest was already confirmed by ITTOIA s.378a (inserted by FA 2009 s.39(3)). Corporation tax payers are subject to the bond fund rules of Ch.3 Pt 6 CTA Offshore Funds Manual, above fn.4, OFM Offshore Funds Manual, above fn.4, OFM08300, Pt 9A CTA (inserted by FA 2009). 84 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.29(3).

13 Current Notes 321 burdensome than reporting fund requirements for TRFs. In addition, the treatment of TRF reported income in line with the analysis in this note gets rid of any confusion between the arising and accruals basis of taxation, although this needs to be confirmed by HMRC. Another incentive for a TF to become a reporting fund is the ability to roll up accumulated reportable income offshore. Even though all TF investors are taxable on an arising basis, a TRF investor will be able to add accumulated reported income to his base cost for capital gains purposes. 85 By contrast, where TNRF investors realise offshore income gains, the 2009 Regulations indicate that the offshore income gain calculation does not benefit from a deduction for any income tax due on accumulated reportable income from reporting sub-funds, 86 although it may get a deduction for income tax due on other sources of arising basis income, such as dividends and interest, under the normal TCGA rules. 87 This potentially leaves a double taxation issue with respect to accumulated reportable sub-fund income within TNRFs, which HMRC do not appear to have addressed. For these reasons, it seems that reporting fund status is generally the better option. Sarah Gabbai * and Tony Stitt ** 85 The Offshore Funds (Tax) Regulations 2009, above fn.2, reg.99(2). 86 The Offshore Funds (Tax) Regulations 2009, above fn.2, regs 39(1) and TCGA 1992 s.37. Capital gains tax; Income tax; Offshore funds * Associate at Fried, Frank, Harris, Shriver & Jacobson (London) LLP. ** Tax Consultant at Tony Stitt Associates.